An extremist, not a fanatic

May 19, 2008

Is the boom in global food prices over? I ask not just because wheat prices have fallen recently, but because Barings plans to launch a global agriculture fund.This is a classic sign of a market peak. For example, after research in the early 1980s showed that small stocks out-performed larger ones, a host of small cap funds were created. Since then, the small cap premium has disappeared. And in the late 90s, lots of tech funds were launched.This raises an important problem with financial innovation - the private costs and benefits of it can differ from the social costs.From the point of view of individual fund management companies, the easiest new products to sell are those that exploit mug punters' desire to get onto a bandwagon. Hence Barings' decision, even though there are already ways to trade agricultural commodities.However, the financial innovation that would be really useful to society would consist in offering us ways to insure against big macroeconomic risks, such as deep recession or decline in particular industries or occupations. But the private cost of developing these, allied to the fact that those who would gain most from holding them are not wealthy, mean they go uncreated. In finance - as in the economy generally - innovation is poorly rewarded.There's a precedent here. It took John Bogle 23 years between spotting that index trackers were a good idea and actually launching the first one. Which shows that the lags between identifying a genuine benefit and creating the financial product that'll serve it can be very long.

May 09, 2008

Some of you have argued that insider trading is morally wrong because insiders have a duty to report material information to their employers, shareholders. But is this possible? The problem is that material information doesn't come in simple, identifiable, bite-sized pieces. It often consists in hunches, suspicions and gut feel.For example. Imagine a small firm wins a big contract. Its CEO announces this promptly, and the share price rises. So far so good. But what if less senior managers have a hunch: "we can't deliver this project on budget and on time. We could get hit by penalty clauses and lose money on the contract." Do these have a duty to make an RNS announcement, even though their belief lacks a hard, empirical, quantifiable foundation and would undermine their CEO?A lot of knowledge, as Michael Polanyi pointed out, is tacit - it can't be convincingly articulated. It's impractical to expect this to be communicated to shareholders by explicit announcements. And a ban on doing so couldn't be enforced at all well.But it can be communicated indirectly. If these managers trade as insiders by selling their stock, the share price reaction to the contract would be muted, or even negative. In this way, insider dealing allows us to learn more about the company than any ban on it, accompanied by harsher disclosure requirements, ever could.

May 07, 2008

The FSA is promising to crack down on insider dealing. No-one in the City feels the need to change his underpants. After all, what chance do public sector workers have of ever recognizing a well-informed decision?Which raises the question. Why should insider trading be illegal at all? How can knowing what you’re doing be a criminal offence? Some good judges think it shouldn’t be. There are (at least) three arguments for legalizing it:1. Insider trading would improve market efficiency, by ensuring prices reflect all available information.2. It would reduce market volatility, by reducing the power of noise traders. Today, people who rightly fear a share is under-priced (or over-priced) are reluctant to buy (or sell) for fear that mug punters will drive its price further away from fundamentals. If the numbers of informed traders rise, this problem will diminish. And lower volatility should mean higher prices generally.3. The only victims of insider trading are ones who choose to be. No-one forces someone to sell a share at £10 if it is worth £15, or to hold a share at £15 if it‘s worth only £10. So, why should insider trading be a crime? One of the stronger arguments is something like this:

Imagine an oil company’s geologist knows he is about to discover a big oil deposit. Before announcing his finding, he and his friends buy the company’s stock at a low price. The gains from his discovery therefore accrue to him, rather than to shareholders. If shareholders fear this will happen, they’ll under-invest in oil companies, with the result that we’ll get too little investment in resource discovery. Efficiency requires that the property right in oil discoveries lie with shareholders, not employees.

But this argument doesn’t justify a law against insider trading. It merely justifies a clause in our geologist’s contract forbidding such behaviour. And such a ban might not be desirable; allowing a little insider trading might be a good way of incentivizing the geologist to find deposits. This is an issue which shareholders and the company should decide. It‘s not to be decided by general laws against insider trading.So, why are there such laws? I suspect they owe more to the power of vested interests than to economic logic. If insider dealing were legal, brokers and financial advisors and other charlatans who offer share tips would lose their credibility. A ban on insider trading protects these quacks. More: here’s an overview of the issues.

April 09, 2008

Imagine someone thinks their house is worth a million pounds. But this is pure fantasy, and it turns out that it's worth just £500,000. Has this person suffered a genuine loss? Is the difference between dream and reality a loss? That's one question raised by the IMF's widelyreportedclaim that the financial sector could lose $945bn on debt securities.The word "could" is important here. This estimate, the IMF says, is "based on potential loan losses that have occurred since the subprime crisis began and over the next two years."Truth is, though, that the number is much less spectacular than the papers think.For one thing, it's much less than equity investors have lost. Worldwide, $5.6 trillion has been wiped off share prices since late October. Few serious people are much troubled by this.And for another, it's not clear how important this is. Before the sub-prime crisis began, some CDOs were not so much marked to market as marked to fantasy. To this extent, banks' losses are the same as our homeowners losses. They are not so much a destruction of real wealth as a wake-up call.Maybe too loud a call. Mark-to-market measures can overstate losses, if one prices securities at the low-point of the market, from which a recovery subsequently comes.Instead, what matters is not the number attached to the losses - that's just a way of getting headlines - but the response to losses. A loss of, say, $5bn might - depending on who suffers it - lead, variously to: no change at all; a small tightening of lending standards; an abrupt withdrawal of credit; a spiral of losses as the fund is forced to sell even good assets in order to plug the whole; or massive widespread losses as the fund goes bust thus exposing many other traders to counterparty risk. Which raises the question. Just how true is the conventional neoclassical view that financial liberalization allows risk to be borne by those best placed to take it? The truer this is, the more likely the effects are to be at the weaker end of the spectrum.And today, we got some encouraging news on this front. HSBC's offer (with snags, natch) to match expiring fixed-rate mortgage deals shows just what should happen in a healthy financial system - the strong lenders should take up the business which weaker lenders refuse.But let's be clear here. The $945bn figure is not important at all. The question is an an ideological one: is the financial system a source of stability, allowing risk to be spread efficiently, or is it instead a source of instability?

April 08, 2008

Is endogenous growth theory right? This is the question raised by the news that GW Pharma's share price has fallen sharply after its Sativex drug failed to beat a placebo in phase III trials - though in fairness, placeboscan be powerful things. This shows just how hard it is to bring new drugs to market; it follows disappointment with Renovo's Juvista.For this reason, the stock market has a downer on pharmaceuticals generally, especially smaller ones. The Aim healthcare sector has fallen by half relative to the All-share in the last four years, as investors fear companies will burn cash in the fruitless pursuit of new drugs.Conventional economics predicts this should happen, because there are diminishing returns to drug research. Companies pick the low hanging fruit first - the easily discovered drugs - but once they've done this they have to spend more and more money to lesser products unless they get lucky. And this is where endogenous growth theory comes in. In some forms, it denies that diminishing returns are so powerful. Instead, it says, success can breed success, as breakthroughs in technology lead to other breakthroughs.However, the experience of GW Pharma and Renovo - and investors' opinion of pharmaceuticals generally - suggests growth, at least in biotech for now, isn't so endogenous and that diminishing returns are hard to avoid after all. So, is the market wrong, or is endogenous growth theory not all it's cracked up to be?

March 17, 2008

Regular readers will know I'm a big fan of Robert Shiller's proposal for macro markets - markets in assets that'll help people spread risk. The absence of such markets is especially irksome now, and not just for the obvious reason that real economic risks seem to have risen. What I mean is that a market in a labour income security - an asset linked to the net present value of labour income, as shares are the NPV of profits - would shed light on at least three interesting questions now:1. What's the effect of higher commodity prices? The conjunction of record-high commodity prices with low PE ratios could be read as a sign that markets now agree with David Ricardo, who pointed out back in 1814 that rising prices of raw materials would squeeze profits. But what impact will it have on labour incomes? To Ricardo, this was a non-issue as he thought wages tended towards subsistence. But it is an issue now. And if we had a market in labour income, we'd at least see what the market had to say about this.2. Why are house prices falling? The glib view is that it's because a bubble's bursting. But could it also be because expectations for long-term labour income are falling? Again, if we had a labour income market, we'd get an idea.3. What will be the real impact of the credit crunch? Clearly, it's hitting share prices. But is this because investors expect lower long-run profits growth as tighter finance crimps otherwise good capital spending? Or is it just because the crunch has raised risk aversion? Again, a market in labour income might shed light.Of course, such a market might will be bedevilled by the same problems that (arguably) afflict stocks - excessive volatility and over-reaction. All I'm saying is that the absence of such a market doesn't just deprive people of a useful means of spreading risk. It also deprives us of valuable information.In light of the collapse of Bear Stearns and various hedge funds, it's easy to forget one thing - that the real scandal about financial innovation is not that there's been too much of it, but that there's been nothing like enough of it.

March 14, 2008

It's a good idea to pay attention to fund managers' opinions, for the same reason that we should pay attention to dog turds on the pavement. So, we should be wary of this claim in the Times:

Fund managers said that investors would flock to gold and predicted the price
could rise as much as 70 per cent higher.

Now, I don't recall too many newspaper articles telling us the gold price could rise 70% back when it was under $600. And gold's annualized volatility in the last 10 years has only been 17.7%, so a 70% rise in a year would be a four standard deviation event. So what's going on here?Granted, there are goodish reasons to believe gold could rise further, even leaving aside gold buggery about the decline of fiat money, for example:1. Asian economies are still growing fast and have high savings ratios. With a shortage of safe assets in the region, this'll maintain demand for gold.2. A weak dollar leads to rising commodity prices, partly because countries who peg their currency to the dollar print more money when the greenback falls.3. Negative US interest rates will sustain demand for gold.However, these arguments are old ones. What gives them especial credence now is not any new power they have, but rather the fact that $1000 gold is drawing attention to them. And we know that it's dangerous to buy assets that are attracting attention (pdf). Maybe especially so now. There are reasons to be wary of the metal:1. Many of the things that have pushed it up - higher credit risk, falls in the dollar and share prices - might be temporary factors. Only a fool would be certain of them persisting. 2. There's a lot of noise in gold prices. The best paper (pdf) I''ve seen on the determinants of gold finds that over one-third of its movements are unrelated to obvious economic forces, even after throwing in lots of dummy variables. 3. High prices mean low expected returns. Yes they do. So, when anyone speaks confidently of gold rising further, I suspect all they are doing is justifying what has already happened. As one of my old bosses was fond of saying, "it's the price that determines the story, not the other way round." But this, of course, is how bandwagons get started.

March 12, 2008

If we could travel in time, what would real interest rates look like? wonders Tyler Cowen:

As you approach the speed of light you move into the future relative to
more stationary observers. So can you not leave a penny in a savings
account, take a very rapid spaceflight, and come back to earth "many
years later" as a billionaire? Hardly any time has passed for you. In
essence we are abolishing time preference, or at least allowing people
to lower their time preference by spending money on fuel. I believe
that in such worlds the real interest rate cannot exceed the costs at
which more fuel can "propel you into the future through time
dilation."

I'm not sure about this. I suspect time preference would still exist, because the costs of travelling into the future will be much greater than the fuel costs.Imagine you were to put £1 in a bank at a 2% real interest rate (not that you can right now) and travel forward 1000 years. You could look forward to picking up £400 million then. But think of the costs involved. Tons of technology would be wholly unfamiliar to you, whilst many of
the things you love - food, football, pubs - will have changed
enormously. You'll be as disoriented as Catweazle was in the 20th century. Except much more so, as he could magically understand the language. But you'll not be able to, any more than the author of Beowulf would understand modern English. If the past is a foreign country, the future is even more foreign.You'll therefore face enormous adjustment costs.What's more, although your 3108 self will feel rich compared to your 2108 self, you'll not be especially well-off compared to other 3108 beings. If real interest rates equal real growth rates, as they should, everyone will be colosally wealthy in 3108. Prices of positional goods - big homes with nice views, art and the like - will be as out of your reach then as now.And then there's risk to consider. If you try to get your £400m in 3108, you might well find that the bank has gone bust or that your dormant bank account has been seized.I reckon these problems would stop many people travelling forward just to become billionaires. Time travel, then, wouldn't put much downward pressure on real interest rates - well, not as much as the Fed does.

Taube is perhaps most famous for anticipating the stock market crash of 1987.
He had been shorting stocks — selling in expectation of a fall in prices —
for several months before the crash, which initially led to heavy losses. By
December, though, he had made a profit of £75 million.

This points to two sources of successful trading that are sometimes overlooked. One is deep pockets. Had Taube not had these, he'd have had to close his positions early, and would never have come good.The other is a pig-headed stubbornness. Without this, Taube might have decided to throw in the towel, figuring "it's one thing to know that markets are stupid; it's another thing entirely to know when they'll see sense."And this raises a question. Could it be that one requirement for success in trading (and perhaps elsewhere) is that one be non-rational, in the sense of beingover-confident, and holding one's opinions more strongly than the evidence warrants? My personal experience of traders suggests so. Maybe markets don't select for rationality.Another thing: The Times contains the saddest line I've read in a long time: "Taube was taken ill last week while sitting
at his Bloomberg terminal at 7.30 in the morning." Doesn't this show the truth of Mr Bernstein's claim in Citizen Kane: "it's no trick to make a lot of money... if what you want to do is make a lot of money"?I was never cut out to be a trader.

March 05, 2008

Guido points out that the FTSE 100 has fallen in the last 10 years whilst other markets have risen - an "incredible indictment" of New Labour, he says.If I were he, I'd not put much weight upon this, for three reasons:1. A slight re-presentation of the data shows a different thing. Comparing total returns on the All-share to those on MSCI's world index shows that the UK has beaten the world over the last 10 years, returning 48.8% against the world's 40.1%. This is because world markets have been dragged down by a fall in the Nikkei; because the All-share has out-performed the FTSE 100, as smaller stocks have done better than big ones; and because the UK market has on average paid higher dividends than other markets.2. A booming stock market is no proof of a healthy economy; the Zimbabwean market is doing well now. Indeed, in a really healthy competitive economy, stock markets would do badly - if they existed at all - because profits would be incessantly bid down by fierce competition. A rising stock market can therefore be evidence of a lack of dynamism in the economy, that incumbent firms are being sheltered from competition. The French market has out-performed the US over the long-term.3. The stock market can rise if profits are expected to rise at the expense of wages. So a rise in the market is consistent, in theory, with bad times for most voters.Now, I'm not exonerating New Labour here at all - merely saying that evidence of its incompetence isn't to be found in the stock market.